Question

Marginal Incorporated (MI) has determined that its before-tax cost of debt is 5.0% for the first $62 million in bonds it issues, and 7.0% for any bonds issued above $62 million. Its cost of preferred stock is 12.0%. Its cost of internal equity is 15.0%, and its cost of external equity is 19.0%. Currently, the firm's capital structure has $325 million of debt, $70 million of preferred stock, and $105 million of common equity. The firm's marginal tax rate is 45%. The firm's managers have determined that the firm should have $50 million available from retained earnings for investment purposes next period. What is the firm's marginal cost of capital at a total investment level of $167 million?

Answer 1

COMPONENT COST OF CAPITAL:
After tax cost of debt (upto $62 million) = 5%*(1-45%) =	2.75%
After tax cost of debt (above $62 million) = 7%*(1-45%) =	3.85%
Cost of preferred stock	12.00%
Cost internal equity	15.00%
Cost of external equity	19.00%
BREAK POINT OF INTERNAL EQUITY:
= 50/(105/500) =	$      238.10	million
BREAK POINT FOR DEBT = 62/(325/500) =	$         95.38	million
Hence, for $167 million debt will be at 3.85% and equity
will be internal equity.
So WACC = 3.85%*325/500+12%*70/500+15%*105/500 =	7.33%